The U.S. Court of Appeals for the Ninth Circuit recently held that a debtor corporation’s sole shareholder and third parties who sold real property and services to the sole shareholder could be liable for fraudulent transfers.

In so ruling, the Ninth Circuit held that the third parties were initial transferees of the debtor corporation’s funds because the sole shareholder paid the third parties with checks directly from a corporate account, even though the third parties did not have a pre-existing relationship or an ongoing relationship with the sole shareholder, his family, or any of his businesses.

A copy of this opinion in In the Matter of WallDesign is available at: Link to Opinion.

As you may recall, the Bankruptcy Code makes a distinction between initial and subsequent transferees when it comes to the recovery of fraudulent transfers.

The trustee and the debtor’s creditors may recover the property (or its value) from “(1) the initial transferee of such transfer or the entity for whose benefit such transfer was made; or (2) any [subsequent] transferee of such initial transferee.” 11 U.S.C. § 550(a).

The trustee and creditors, however, may not recover the property or its value from a subsequent transferee if that transferee accepted the property “for value …, in good faith, and without knowledge of the voidability of the transfer.” Id. at § 550(b)(1).

In 2002, the sole shareholder of the debtor corporation opened a separate corporate account and deposited certain vendor rebates into that account over a 10-year span. The sole shareholder concealed the separate account from the debtor corporation’s general ledgers and later attempted to conceal its existence from the bankruptcy court.

The sole shareholder used the separate account for personal expenses. The sole shareholder purchased real property from real property sellers and design services from an interior designer. The sole shareholder made these purchases using corporate checks drawn on the separate account. Neither the sellers nor the interior designer had a pre-existing relationship or an ongoing relationship with the sole shareholder, his family, or any of his businesses.

In 2012, the corporation filed for bankruptcy. The unsecured creditor’s committee sought to avoid certain transfers made from the separate account, including the payments to the sellers and the interior designer. The bankruptcy court found that the sellers and interior designer were subsequent transferees entitled to the safe harbor under § 550(b)(1).

The trial court reversed the bankruptcy court’s decision and found that the sellers and interior designer were strictly liable to the committee because they qualified as “initial transferees” of the fraudulent payments. The Bankruptcy Appellate Panel affirmed the trial court’s decision.

The Ninth Circuit began its analysis by noting that it had adopted the dominion test for determining who is a transferee for purposes of Section 550. Under the dominion test, a transferee is one who has dominion over the money or other asset. The dominion test turns on whether the recipient of funds has legal title to them and whether the recipient has the ability to use the funds as he sees fit. The Ninth Circuit explained that the test focuses on whether the recipient of funds has legal title to them because dominion strongly correlates with legal title and dominion is akin to legal control.

The Ninth Circuit then observed that courts have taken two approaches when applying Section 550 to fraudulent transfers involving the misappropriation of corporate funds by company directors, officers, or other insiders.

Under the majority approach (which the Ninth Circuit follows), a principal of a debtor corporation who misappropriates company funds to satisfy personal obligations is not an initial transferee because the mere power of a principal to direct the allocation of corporate resources does not amount to legal dominion and control, which is required for initial-transferee status.

In contrast, under the minority approach, corporate principals may be strictly liable as initial transferees when they misuse company funds for personal gain. Under this “two-step transaction” approach, the debtor company is deemed to have made the initial transfer to the corporate principal, thus making him or her strictly liable as the initial transferee.

The Ninth Circuit explained the merits of the majority approach. The Ninth Circuit pointed out that the “flow of funds” matters and that receipt of the transferred property is a necessary element for that entity to be a transferee under section 550. The Ninth Circuit found that simply directing a transfer, i.e., such as directing a debtor to transfer funds, is not enough.

In addition, the Court reasoned, section 550(a)(1)’s structure indicates that a principal does not become an initial transferee simply by using his or her control over corporate assets to effect a fraudulent transfer because section 550 imposes strict liability on both initial transferees and any beneficiaries of the fraudulent transfers. Thus, the Ninth Circuit held that section 550 indicates that initial transferees and beneficiaries are separate persons.

Finally, the Ninth Circuit found that the alternative approach (under which every agent or principal of a corporation is deemed the initial transferee when he or she effected a transfer of property in his or her representative capacity) both misallocates the monitoring costs that section 550 seeks to impose and deprives the trustee of a potential source of recovery for creditors. The Ninth Circuit observed that recovery from an embezzling principal would be difficult, thus Congress also made the first recipient of those funds liable to returning them.

The Ninth Circuit then held that the sellers and the interior designer were initial transferees because legal control over the funds had never passed from the corporation to the sole shareholder. Recall that the sole shareholder had paid the sellers and the interior designer using checks drawn on the corporation’s account, albeit a concealed, separate account.

Thus, the Ninth Circuit found that section 550 allowed the trustee to recover funds from the sellers and the interior designer as initial transferees and from the sole shareholder as the beneficiary.

Judge Nguyen dissented from the majority’s opinion. Judge Nguyen suggested that the Ninth Circuit should abandon its dominion test, in favor of the control test used by other circuits. Under the control test, courts “view the entire transaction as a whole to determine who truly had control of the money.” In addition, Judge Nguyen argued that the debtor corporation did not have legal title to the funds prior to the transfer as a matter of state law. Judge Nguyen argued that under state law, the sole shareholder converted corporate funds by transferring them into his personal account, making him the initial transferee.